Wednesday, December 12, 2012

The Fed targets $45 billion in treasury purchases a month; why then did treasuries sell off?

The Fed has announced that in addition to the $40 billion of monthly MBS purchases, it will also commence $45 billion in treasury purchases. This unprecedented open-ended program will swell bank reserves and ratchet up the monetary base.

The announcement of this new asset purchase program should be a big positive for treasuries, right? Turns out that it wasn't. Longer dated treasuries rallied immediately after the announcement, but sold off shortly after, now trading at the lows for the week.

10y note futures (source: Barchart.com)

30y bond futures (source: Barchart.com)

With the FOMC doves running the show, the Fed announced it would target a specific combination of unemployment and short-term inflation expectations.

Bloomberg: - Thirty-year yields reached a one-month high after the Federal Open Market Committee said interest rates will stay low “at least as long” as the jobless rate stays above 6.5 percent and inflation “between one and two years ahead” is at no more than 2.5 percent.

The two-year inflation expectation (the so-called breakeven rate) however now stands at about 1.3% - which means the Fed has given itself quite a bit of room to get to 2.5%. And that was the reason for the selloff - such an open-ended policy clearly runs inflation risks.

Bloomberg: - “The Fed is losing some of its credibility as an inflation fighter,” said Gary Pollack, who helps manage $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “They will allow inflation to go above the long-term target. That’s disappointing for the market.”